The Financial Services Authority

Regulator, heal thyself

Teething troubles at Britain's financial regulator

TO BE effective, a financial regulator needs three things: a sound operating structure; sensible procedures and competent staff; and credibility so that wrongdoers are properly punished and others deterred. There are worrying signs that the Financial Services Authority (FSA), now Britain's only financial regulator, is falling short on the latter two counts.

This week an independent tribunal made stinging criticisms of the agency's handling of a case involving the alleged mis-selling of endowment mortgages by Legal & General, a big insurer (see article). While accepting the FSA's verdict that there had been mis-selling, the tribunal nevertheless lambasted the way the regulator reached its decision to fine the insurer £1.1m ($1.9m). This embarrassing ruling came only weeks after the FSA reached a settlement over a long-running scandal involving so-called split capital investment trusts. Consumers lost more than £600m on funds that were sold as low risk, then turned out be high risk. After months of obstructing the regulator, 18 banks and brokers agreed to pay a modest £194m in compensation, but admitted no guilt.

These cases have put the FSA on the back foot. There have been calls for its chairman and chief executive to resign or be sacked by the government. There have been suggestions that the whole idea of creating a single financial regulator is flawed and that a few specialist agencies would do a better overall job. Voices in the City of London are even muttering about the FSA's regulatory regime becoming a handicap that might allow rival financial centres to steal business.

All of these should be ignored, for now. The FSA is a young body that deserves more time to sort out what probably amount to teething, rather than fundamental, problems. Its full unitary powers came into force only this month, and it is far too early to condemn the effort to bring together once disparate regulatory functions under a single umbrella. That combination has been difficult, and it has mostly been done well. But this does not mean the FSA should be complacent. It has serious failings that it must address.

Start with its procedures. These seem inadequate. The tribunal this week pointed out that the case against Legal & General relied on too little evidence and included arbitrary changes of position. That is damning: a regulator cannot use flawed procedures without destroying its effectiveness. Similarly, the FSA relies on continuous monitoring of financial-services companies to keep it informed and allow it to issue warnings when necessary. If the monitoring is poorly constructed, as many argue it is, then the FSA will find itself struggling. Big investment banks claim, with some justification, that their risk-taking is unnecessarily micro-managed by the FSA, which should focus more on the systemic implications of one of them going bust. By contrast, the long-term balance-sheet risks being run by big providers of retail products, including life insurers, are not monitored closely enough. The same is true of the increasingly complicated products they sell to (often ignorant) consumers. The FSA's bosses need to make sensible changes in both disciplinary and monitoring procedures and then explain clearly what the new rules are.

Getting it right

The question of competence is more complex. It would be too harsh to conclude that the FSA is incompetent. But it cannot escape a problem faced by many regulators: that the salaries which it can offer are much lower than those offered by the industry it oversees, meaning that the top talent is usually on the other side. The agency's sharpest critics say it has plenty of staff but an insufficient aggregate IQ. The jibe hurts because, in an era of highly complex financial engineering, it has an element of truth. Over time, however, the regulator's staff will learn. And better procedures will make the FSA's competence (or lack of it) more evident. The long-term trick will be to retain good staff so that they can apply their knowledge to protect consumers and markets over long periods. That might mean introducing tighter rules on transferring from the FSA to jobs with regulated firms, something its founding boss and a head of enforcement have done with alarming speed.

But the biggest challenge for the FSA is to establish the credibility it currently lacks, and urgently needs in order to serve the public interest. If it genuinely tackles the kind of problems that initially dog any big project, then there are still good reasons to believe that the bold experiment of creating a unitary financial regulator in London will be judged a success, perhaps even by those it is regulating.